What Patent Cliff? Pharmaceutical ETFs Continue To Surge (PJP, XPH, IHE, JNJ, PFE, AMGN, MRK, VVUS)

Eric Dutram: For at least the past few years, investors in the health care segment have been focused in on big pharma and the segment’s fast approaching ‘patent cliff’. During this period, many of the industry’s most popular and best selling drugs go off patent and will face heavy generic competition, slashing profits for many members of this group.

To top things off, there is little in terms of new drugs to replaces these blockbusters, suggesting that once companies go past this cliff they will have significant trouble coming back. In fact, according to The Economist, blockbusters with a combined $170 billion in annual sales will go off-patent by 2015, creating a life-threatening situation for many of the top companies in this sector (see more in the Zacks ETF Center).

Given this bearish outlook, many analysts and bloggers, including myself, assumed that the pharmaceutical sector would be in for a world of pain leading up to and immediately following this cliff. However, the sector has proven to be incredibly resilient over the past few years and has, shockingly, outperformed many other segments of the health care industry and even the broad economy over the past few years.

Instead of slumping, the pharma ETFs have been among the top performers in the equity exchange-traded fund world over the past few years. In fact, of the three pharmaceutical focused ETFs that have been around since 2009, all of them have at least doubled in the past three year period (also read The Five Best ETFs over the Past Five Years).

This incredible performance puts these products into elite company in terms of equity ETF investments that are focused on the U.S. market. Just 15 products have doubled in this time frame while the S&P 500 added about 53% in the same period, demonstrating just how well pharmaceutical stocks have done despite the headwinds facing the industry.

How They Did It

Seemingly, many analysts heavily discounted pharma’s foresight and ability to plan for this upcoming issue. The industry has been hard at work building up cash reserves and deploying them on small biotech/pharma firms in order to boost nearly empty pipelines.

Already, firms in the space are finding targets in the mid cap segment, scooping them up in order to obtain access to their more impressive drug lineups, potentially taking some of the pressure off of big pharma for the time being.

It also appears as though drug companies have become much shrewder about how they fight generic competition. In an Economist article, it is revealed that Pfizer worked with an American firm in order to help break apart a 180 day generic exclusivity period, helping the company compete with often times cheaper generics.

The company also seems to be partnering with big health care providers in order to give them cheaper drugs, thereby at least getting some inflows based on sheer volume. The article also claims that these practices have helped to boost sales by over half a billion in the first half of 2012, taking at least some of the pain of the patent expiration out of the equation.

Lastly, the recently passed, although still controversial, Obamacare bill could also help big pharma in the years ahead. Should millions of Americans be forced to get insurance and thereby have access to drugs, it could open up a whole new market for these firms that was out of reach until now, potentially boosting sales in the process (read Health Care ETFs in Focus on Obamacare Supreme Court Decision).

Clearly, pharmaceutical stocks have managed to take some of the points above to help dispel at least a few of the worries that investors have about the segment’s massive patent cliff. Should this continue, pharma could remain an intriguing choice for investors, especially if dividends remain high and if the sector can act as a safe haven for those concerned about the health of the global economy.

For investors who believe that this trend can continue in the face of headwinds, we have briefly highlighted some of the choices in this space below:

PowerShares Dynamic Pharmaceuticals Portfolio (NYSEARCA:PJP)

This product has been the second best performing ETF targeting the U.S. market over the past three years, adding over 125% in the time frame. Additionally, the product has added more than 18% so far in 2012, trouncing the S&P 500 in the process.

This PowerShares fund has about 30 stocks in its basket, charging investors 63 basis points a year in fees. Volume is pretty solid at about 100,000 shares a day, suggesting relatively narrow bid ask spreads (See Medical Device ETFs: A Better Way to Play Health Care?).

Growth stocks and large caps comprise the bulk of the fund, although value securities make up about 33% of the portfolio while small/micro caps account for about the same amount from a cap perspective. In terms of holdings, Merck (MRK) takes the top spot and it is closely trailed by Johnson & Johnson (NYSE:JNJ), and Amgen (NASDAQ:AMGN).

SPDR S&P Pharmaceuticals (NYSEARCA:XPH)

XPH has been the second best performing pharma ETF over the past three years adding a very respectively 110% in the time period. The product has also done quite well from a year-to-date look as well, as the fund has moved higher by about 15.6% during that time frame.

XPH also holds a basket of about 30 securities but does so at a low 35 basis point cost. Volume is also pretty good at about 90,000 shares a day, suggesting that total costs in this fund are likely to be minimal (read Forget Big Pharma It Is Time For A Biotech ETF).

Growth securities make up almost 60% of the assets while large caps account for just over one-third of the total, suggesting that the product has a tilt towards smaller more quickly growing securities. This is probably in part due to the equal weight nature of the fund which allows for smaller caps to receive bigger weightings.  Currently, the top two holdings include Vivus (NASDAQ:VVUS) and Questcor (NASDAQ:QCOR), demonstrating the focus on smaller pharma firms.

iShares Dow Jones U.S. Pharmaceuticals ETF (NYSEARCA:IHE)

IHE barely squeaked by into the 100% gain club over the past three years, adding 101.1% in the last 36 months. Meanwhile, over the course of 2012, the product has put up a solid 14.7%, a little lower than the other products on the list but still much better than broad health care funds in the same time period.

This iShares fund has the biggest selection of securities in its portfolio, holding 38 companies in total. The product charges a middle-of-the-road 47 basis points a year in fees while volume is somewhat light at 45,000 shares a day (See the Guide to the 25 Most Liquid ETFs).

The fund is cap weighted so there is a much bigger focus on the giants of the pharma world, as evidenced by the relatively high levels of value securities (38%) and the majority of the assets going towards large cap stocks. Still, this puts some solid household names in the fund including high weightings to companies like Johnson and Johnson, Pfizer (NYSE:PFE), and Merck.

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Written By Eric Dutram From Zacks Investment Research 

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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